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The Brewing Credit-Card Storm

Credit-card issuers, already reeling from a weak economy, may take another financial hit if regulators have their way. In early May the Federal Reserve Board unveiled a proposal that would limit interest rate hikes, abolish certain fees, and modify controversial billing practices—targeting what officials consider to be abuses. But such regulations would likely erode profits, a cost that card companies may ultimately pass on to their borrowers. Says Kenneth Clayton, general counsel at the American Bankers Assn.: "While the proposal might address certain issues, it might unintentionally create bigger problems for consumers."

The proposed rules, developed in conjunction with the Office of Thrift Supervision and the National Credit Union Administration, mark the first time in more than 20 years that a government agency has proffered an outright ban on certain industry practices. And despite protests from the issuers, the new regs are expected to go into effect by the end of this year. "The proposed rules are intended to establish a new baseline for fairness in how credit-card plans operate," Fed Chairman Ben Bernanke said on May 2.

The plan will likely hit credit-card companies where it hurts most—their profits. With more consumers falling behind on payments and losses rising in recent months, issuers have been raising rates aggressively for all types of borrowers. The new rules would severely limit the industry's ability to make such adjustments. Under the plan, banks could increase the rates they charge borrowers on future purchases. But they would not be allowed to hike rates on outstanding balances, as they can now.

Banks would also have to allocate payments equally to consumers' high- and low-rate balances. Currently, payments are first applied to those at the lowest interest rate, which makes it more costly for consumers to pay off their debt. "Clearly, we're looking for more flexibility [in the rules]," said Steve Freiberg, CEO of Citigroup's global cards at the company's meeting with analysts in May.

And the proposal would slow the stream of fees, at least temporarily. The altered rules would grant consumers a grace period of 21 days before banks could assess a late-payment fee. Some companies only give consumers a couple of days before hitting them with a penalty. Banks also wouldn't be allowed to impose a tariff when customers open new accounts.

Don't expect the industry to suffer for long, though. Many industry experts predict issuers will simply find other ways to make up the difference by hiking fees or boosting the rates they charge from the outset. Citigroup (C) has indicated it probably will reduce the number of teaser rates—introductory offers that jump after a specified period. Borrowers with bad credit may see limits cut or be denied cards altogether. "We are going to see a further tightening of credit," says Dennis Moroney, an analyst at consultant Tower Group (TWGP). "The riskiest consumers will be hit the hardest."

Even so, consumer advocates and politicians say the rules are necessary to help protect borrowers. And they're pushing for more reforms that address other contentious practices like marketing on college campuses and charging interest rates on fees. "[The plan] stops short on other blatantly unfair practices," says Senator Carl Levin (D-Mich.) But the rules "curb a number of serious abuses."

Join a debate about regulating credit card rates.

To watch a video report on what the Fed considers unfair and deceptive practices in the credit-card business, go to businessweek.com/go/tv/credit